Bonds away! I mean, far away

One strategist not worried about surge in 10-year rates

ThomCalandra

SAN FRANCISCO (CBS.MW) -- When was the last time the benchmark Treasury put on 150 basis points of yield in a six-week stretch?

Got me, but the 10-year Treasury note's nearly 4.6 percent yield Friday is an entirely different world from the one that was 3.076 percent on June 16.

At the start of the summer, the headlines did not include $450 billion government spending deficits. The home refinancing boom seemed endless.

Today, there are rumblings that overseas investors, pension funds and other governments, the folks who buy more than half of all U.S. Treasury debt, are cashing in their chips. The Japanese hold the most, more than $400 billion worth by some estimates. The Chinese, said to be diversifying into gold, are second on the list with about $125 billion of Treasury securities.

Meanwhile, the spread, or difference in yields, between the 1.76 percent interest rate on the two-year Treasury
TMUBMUSD02Y, +1.50%
and the 4.51 percent rate on the 10-year
TNX, +3.06%
is at an all-time high.

Just this week alone, the 10-year yield's rise amounted to about 40 basis points, as of early Friday, when the U.S. jobs report sent the rate to 4.6 percent, the highest in a year.

Those who make a living in the sub-grade bond market -- issuers of so-called junk bonds that offer far higher yields than high-quality Treasury and corporate securities -- are starting to bite their nails. Junk bonds, along with convertibles and other areas, even municipal bonds, had a great run from October 2002 through mid-June.

Now, the party may be over. High-yield bond funds in America saw $1.06 billion of mutual fund outflows in the week that concluded Wednesday. The record-high one-week outflow for high-yield bond funds is $1.4 billion, set in September 2002, says AMG Data Services.

Other things are going awry in bond markets. So-called swap spreads are getting wider and wider as bond investors cash in their securities and head to the sidelines. In two days, the swap spread, a basic sign of interest-rate risk, thickened by almost 20 basis points, an ungodly amount in that period of time.

There are early, dark ruminations that investors who borrow yen to buy Treasury bonds may be heading for the exits. That trade, known as the yen-carry trade, uses cheap yen, with a borrowing rate of 1 percent or less, to buy higher-yielding and dollar-linked Treasury notes and bonds. But as the yen gains against the dollar, and Japan's minuscule rates on its government bonds appreciate, yen-carry investors, having mortgaged their livelihoods to a cheap yen and a flat Japanese economy, can get caught in a horrible crunch when it's time to pay off their loans.

Not everyone is nervous about the state of the bond market. After all, in the past nine months, surging bond prices have made many traders and portfolio managers quite wealthy.

"I'm not really worried about the bond market. What we've got going on is a rise in real rates, on the heels of an expected pickup in economic growth and capital spending," says Michael T. Darda at supply-side think tank Polyconomics in New Jersey.

"If the fall in the dollar goes too far, with gold at or above $400 an ounce, and commodities close behind, then we could see a negative, inflationary oriented move in long rates. But at this point, I think we have a reflation and an expected recovery, which is moving up the returns to capital and placing upward pressure on market-clearing interest rates," Darda says.

The economist's model for the 10-year Treasury takes the 50-year "real" rate and then adds the TIP spread as the "inflation component." TIPs are inflation-linked Treasury bonds. Darda's model puts fair value for the 10-year bond yield "right around 5 percent, but that's really the very top of the range I think it will be in."

Overall, Darda is a believer in the U.S. economic recovery. "We think the revaluation of the dollar from excessively strong to a nondeflationary level and lower tax rates on capital will combine to boost the pace of economic growth, profits, inventory building and capital spending," he says.

If he's right, and this year Darda has been on the money about many ways to profit from the economic recovery, then the stock market has plenty of steam left in it.

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